What Drives Forex Rates?

As we head into the home stretch of the summer of 2004, we can be relieved that the thin, erratic markets will be drawing to a close, but there will still be lingering questions as to price levels moving forward.  In such a period where one of the most aggressive monetary expansion policies draws to a close, it is little wonder that the market is seeking a whole host of inputs/variables in order to determine exchange rates.

Presently, the market is putting a significant amount of weight on rates, specifically US rates, as a gauge to overall economic strength.  The result has been some solid moves higher in the reflation trades, i.e. JPY, NZD, CAD and AUD.  While the move higher has been erratic at times, due to the explosion and implosion of commodity prices, it has been the correct play. 

It is likely that rates will continue to play a key role going forward.  Evidence of this is easy to come by.  Witness the moves in EUR/CHF in June and July when perceptions of SNB monetary policies were changed.

In fact, we presently feel that this cross is vulnerable to further downside moves to the 1.5300 level.  The Swiss economy is growing at a more solid clip than is the rest of Europe.  December ’04 futures are likely underestimating rate rises in Switzerland by year-end.  Look for a 50 bp move by then.  In the meantime, it is a tough short trade when viewed technically.  The persistent grind higher is tough to fight.  Specific economic data, comments from the SNB or a technical break of 1.5375 will usher in shorts.

Oil & FX

While the price per barrel of oil continues to grind higher, one cannot help but notice that currencies that are particularly sensitive to oil prices have risen in recent sessions.  Witness the Yen in recent sessions.  Is it possible that this move higher in the Yen is signaling a coming fall in oil prices or if the rise in the Yen simply due to capital flows?

Other “reflation” currencies, i.e. CAD, AUD and NZD have also firmed up in recent sessions.  The US stock market has also defied higher oil prices.  While this may be merely coincidence, or the fact that risk averse investors are seeking out yield remains to be seen.  Whatever the case, a drop in oil prices will likely propel these currencies higher.

Source:  UBS

The Pound

Technicians are giddy as the GBP/USD is in the process of sorting out a nice head and shoulders pattern on the daily chart.  While we agree that this is a compelling pattern, we also feel there is some solid macro evidence that justifies a short in this pair.

-          House prices rose at their slowest pace in a year in July. The number of property sales also fell for the fourth consecutive month in July, according to the Royal Institution of Chartered Surveyors.

-          There is initial evidence that interest rate hikes are beginning to negatively impact the U.K. consumer. The consumer has been the primary driver of U.K. growth for quite some time. Retail sales fell 0.4% in July. This was the first drop in retail sales in over a year. Therefore, the BoE will likely be careful regarding further rate hikes if this data persists.

A break of this neck-line, should set the stage for a move towards the first support area of 1.7790.  From there a true H&S pattern would signal a move ultimately towards 1.7580.  The weekly chart confirms a break could occur as momentum and oscillators point to lower prices.

In summary, while there are some solid trades in the making, it is tough to have a high degree of conviction with Labor Day fast approaching and most trading desks sparsely staffed.  Nonetheless, longs in AUD, CAD and NZD seem reasonable on short-term models.  Longer-term, the EUR/CHF should present us with solid short as well as the GBP/USD.

Thus far for August we have maintained a positive total return, albeit modest.  However, with the way the markets traded, we consider ourselves very fortunate.

As always, feel free to send me your comments and questions.

Dave